Recognizing that all distributors are not created equal, some manufacturers are moving toward functional or activity-based discount structures to compensate channel partners.

by Richard Vurva

You get what you pay for.

Or do you?

Because distributors come in all shapes, sizes and abilities, some manufacturers are starting to question traditional distribution compensation programs.

Traditionally, a manufacturer offered a basic discount to any distributor it authorized to sell its products. Plus, if the distributor bought enough products, the manufacturer kicked in an additional volume discount. Then they added special deals into the mix (published and unpublished), end-of-month specials, promotions and so on. Most of these discounts had nothing to do with the needs of the end customer or efficient supply chain behavior.

In the past few years, however, a growing number of manufacturers have started to question whether the old way is the best way. Why not compensate distributors for the specific functions they perform? Instead of treating them all the same, can’t we recognize them for their differences?

The result is that some manufacturers are moving toward functional or activity-based discount structures in which they reward distributors for performing specific functions. For example, they may offer a better discount to distributors that have certified salespeople. They may offer another discount to distributors that provide them with point-of-sale information. Other common activities that suppliers may reward with discounts include utilizing electronic funds transfer, making prompt payments or participating in joint market planning.

Writing in the “Handbook of Business Strategy,” here’s how Sam Shapiro of Frank Lynn & Associates describes functional discounts:

“Under a functional discount structure, the supplier breaks its traditional discount into discrete functional components. For example, a manufacturer that formerly offered a 50 percent discount could offer a base discount of 25 percent and additional discounts of 10 percent for logistics, 5 percent for pre-sale support, 5 percent for post-sale support and 5 percent for credit and transaction processing. While many distributors will continue to earn the full 50 percent, only those that perform a subset of the functions earn reduced compensation.”

So, with functional discounts, manufacturers finally get what they pay for.

Motivation is the key
Why are functional discounts becoming more common? Manufacturers want to motivate good behavior. They want to prod their channel partners to do the things that generate demand, create customer satisfaction and take costs out of the supply chain.

The other reason they’re becoming more prevalent is because some manufacturers are moving away from traditional volume-based or quantity discounts. Why? The quantity discount causes manual intervention in order processing. Every time a distributor places an order, he has to determine the best quantity to buy to get the best price. Manual processes are more costly to perform than automated processes. Plus, volume discounts cause distributors to order products they don’t need and can’t sell (see sidebar, “Will volume discounts disappear?”).

The newer discount structures are growing in popularity for two reasons, says Shapiro, who specializes in supply chain pricing and compensation strategies.

Historically, manufacturers gave a discount to a distributor for performing the entire distribution function, including sales, logistics, credit, order processing, and possibly some services such as assembly or kitting.

Now, manufacturers are discovering that third parties can perform one or more of those functions more efficiently than a distributor. For example, suppose a manufacturer hires a third-party logistics (3PL) provider to hold inventory. The manufacturer would no longer want to compensate its distributors to perform the inventory function if the 3PL performs that function. They’re effectively saying to distributors, “We don’t need you to do this anymore, so we’ll keep some of that money ourselves.”

There’s another, perhaps more common, reason suppliers are looking at revising their discount structures. Simply put, some distributors are better than others.

“Because some distributors perform functions better than others, the manufacturer wants to recognize and compensate that distributor for its performance by giving it a deeper discount for that activity,” Shapiro says.

Gaining control
When Loctite Corporation began examining its distribution network about three years ago, it discovered something amazing. Although Loctite had an authorized network of 257 distributors with 2,000 branches that could sell its full line of products through sourcing agreements, 16,000 distributors in the U.S. called themselves Loctite distributors.

It was a practical and physical impossibility for Loctite to provide service and support to all 16,000 distributors. And it would be financial suicide to give the same discount to each distributor.

Distributors that have experienced sales staffs with technical or engineering backgrounds don’t require nearly as much support in the field as a distributor that does nothing more than put a few cases of 242 Threadlocker in its warehouse.

So Loctite, with input from its distributor advisory council, began working on a new approach that would help take cost out of the channel and build a value proposition for authorized distributors. Loctite implemented many of the council’s recommendations, which led to adopting a master distributor arrangement, terminating 47 percent of its distributor network and moving toward a compensation structure that recognizes unique strengths of distributors.

“We recognized that due to the strength of our brand we cannot control availability of our product, so we’re not going to try,” says Kevin Boyle, director of channel management. “But we are going to be much more selective about which distributors we work with.”

First, it segmented its products into three categories: OEM, industrial and MRO, then determined what distributors bought which products. The next step was to set up a discount structure based on the distributor’s expertise and the type of products it sold. For example, distributors that sell Loctite’s OEM products typically have salespeople with a skill profile suited for specification selling and have also invested in a support staff with technical skills. These distributors generally require less technical support from Loctite, which earns them a better discount. But when an OEM distributor sells an MRO product, the distributor doesn’t get the same discount an MRO distributor earns.

Boyle says the program took a great deal of work to put together and couldn’t have been done without input from Loctite’s advisory council.

“It’s a lot of work, but it’s starting to pay off,” Boyle says.

He says the effort is still in its beginning stages. Next year, Loctite will reward distributors for accepting electronic invoices (810 Invoices) and for paying their bills via electronic funds transfer (EFT).

“Our advisory council told us an 810 Invoice reduces a distributor’s costs,” he says. “They also said EFT helps the manufacturer more than it helps the distributor. But if we do it in unison, it’s a handshake. It’s a win-win.”

Loctite’s advisory council is looking at developing functional compensation based on training, providing point-of-sale information and order efficiency.

“We’re focusing on taking costs out of the process as well as on growing top-line sales,” Boyle says.

Separate, then compensate
That’s essentially what hose manufacturer Aeroquip did when it established three distribution classifications with unique discount structures. Ed Ruttan, director of distributor markets for the Aeroquip Group of Eaton Corporation, says the switch satisfied two key issues: The company needed more outlets (not necessarily more distributors) and needed facilities closer to end-user customers.

So, Aeroquip established three types of distributors — premier, authorized and affiliates — and compensates them accordingly. To be called premier, distributors must meet certain inventory, technical and training requirements, maintain proper hose assembly equipment and employ properly trained and certified product specialists. Authorized distributors offer some, but not all, of the services that premier distributors provide customers. Affiliates can sell the Aeroquip brand, but they buy it from and are serviced by the premier distributors.

“We don’t follow a policy of just trying to set up distributors everywhere,” says Ruttan. “We look at markets and figure out what the need is and try to get as good a match as we can in that market.”

He says the approach works because it appropriately rewards those distributors that perform more services, yet still allows others to carry the product.

“Customers love service. They like people who can provide more, not less. The premier distributors have more capabilities, so it makes them more viable in the marketplace,” he says.

Not every manufacturer will migrate toward functional discounts. Programs can be difficult to develop and cumbersome to monitor.

Bob Gardiner, director of marketing and distribution for Norton Company, says one reason Norton decided not to implement a functional discount program is because it is difficult to put a compensation model in place that appropriately recognizes distributors for their varied roles.

“It became obvious to us that the implementation of this would be highly administrative and complex and would be perceived in the marketplace as unfair,” he says. “Our distribution community serves many customers — for the most part, many customers in numerous industries. Each customer has different priorities. As a result, customers ask them to take on different roles and functions.”

For some customers, distributors provide inventory management services, training and technical support. For others, the distributor simply takes orders. Gardiner says it would be impractical to set up a discount program that recognizes each of the functions distributors perform for each customer set.

Not for everyone
Make no mistake, functional discounts represent a major change for manufacturers and distributors. In order for them to work, the manufacturer must develop a program that treats distributors fairly and uniformly, then have the administrative capability to monitor the program.

“If you have a functional discount structure or activity-based program around inventory or sales, that means you have to be able to measure the performance of your channel partner,” Shapiro says. “You have to put in an infrastructure to measure performance and communicate that to the channel.”

Brush and abrasives manufacturer Weiler Corporation is in the second year of a three-year effort to migrate to an activity-based channel compensation structure. The program has been well received so far, but vice president of marketing Rich Poole recognizes that complete implementation has its risks. In the final phase, as distributors perform the activities, they receive compensation.

One of the activities is a prompt payment criterion. If the distributor chooses not to pay within the stated terms, it puts the manufacturer in the uncomfortable position of playing the bad guy. Which brings up another dilemma.

Manufacturers that don’t have strong relationships with their distributors risk upsetting the network. Rather than lose a discount because they can’t or won’t perform a specific function, the distributor may choose to do business with another supplier.

Despite its uncertainties, Poole believes the activity-based model is still the best way. The alternative is to reward distributors for work they may not do, which ultimately adds cost to the channel.

“If someone doesn’t support you in the local market, just carries your brand as a secondary line, is that a full, authorized distributor? No. He’s not performing all the functions that you, as a manufacturer, want accomplished in that local market. As manufacturers, we should reward the distributors who do what we need them to do,” Poole says.

In other words, pay for performance but do not reward non-performance.

“All distributors are not created equal,” says Loctite’s Boyle. “They all have their own strengths, so let’s recognize them for their individuality. Let’s identify each distributor by its strengths and build a channel compensation structure based on what it contributes.”

This article originally appeared in the May/June '01 issue of Progressive Distributor. Copyright 2001.

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